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Written by: Tim Pierotti
I recently read Stephanie Kelton’s best-selling book The Deficit Myth. Dr. Kelton is a professor at Stony Brook University, and she is one of the leading proponents of Modern Monetary Theory. I write and talk a lot about the risks of secularly higher inflation that I believe will be, in part, driven by excessive deficit spending, so I wanted to get a better understanding of a popular theory that seems to posit the idea that deficits don’t matter.
Dr. Kelton makes several fair points in the book. The best among them is that when pundits or politicians claim we are running out of money, they are either dishonest or ignorant of the fact that as a sovereign nation with the power to print the global reserve fiat currency, we will never run out of money.
She also correctly notes that for decades the Fed and policy makers have been dead wrong about the level of unemployment that would incite inflation. It wasn’t that long ago that economists and Fed officials believed that NAIRU (Non-Accelerating Rate of Unemployment) the rate of unemployment where inflation would be expected to rise was 7%. Then it was 6%. Then it was 5% and there was still no inflation. The result of these mistakes is that the Fed has kept policy too tight for decades across cycles and the result of that is that the economy has grown below capacity.
Dr. Kelton argues that it hasn’t just been the Fed that has unnecessarily restrained the economy but so have policy makers on both sides of the aisle that have been far to austere in restraining government spending when there was no risk of inflation in sight. But here we find the problem: Inflation is not just in sight, but we are in the battle now. The book’s title is misleading. A less punchy but more informative title might have been: The Deficit Myth…Unless Our Economy has Low Potential GDP Amid Yawning Deficits. To quote from the book,
“Every economy has its own internal speed limit, regulated by the availability of our real productive resources, the state of technology, and the quantity and quality of its land, workers, factories, machines, and other materials. If the government tries to spend too much into an economy that is already running at full speed, inflation will accelerate.”
That is exactly the situation we now find ourselves in. Potential GDP, the rate at which the US economy can grow, without eroding the buying power of consumers, has declined to somewhere around 1%. Look at the first half of this year. Growth (as defined by the average of GDP and GDI) has been around flat to up 1% and yet, the Fed’s job after 525 bps of hikes is not for certain complete. The core issue is wages, which are still running somewhere between 4.5% and 6.3%. To quote Former Fed Vice Chair and current head of the National Economic Council (NEC) Lael Brainard,
“To the extent that the lower elasticity of supply (tight labor markets) we have seen recently could become more common due to the challenges such as demographics, deglobalization…it could herald a shift to an environment characterized by more volatile inflation compared with the preceding few decades.”
Kelton writes, “A deficit is only evidence of overspending if it sparks inflation”. For decades, we ran deficits and inflation fell. That is no longer the case. Our budget deficits have grown while at the same time we have secularly tight labor markets that are finally testing NAIRU. Unemployment is 3.5% and labor participation is bumping up against multi-decade highs. We need both political parties to reduce the current excessive deficits and to stop stimulating demand while the Fed is attempting to do the opposite. Unfortunately, my confidence in Congress to resist the populist pull and govern prudently is likely less optimistic than the people over at Fitch.
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